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November 14, 2012

Rogoff and Reinhart’s Mountain of Debt Warning Catches Fire

MFS’ Swanson and Morgan Stanley’s Mackay point to Harvard historians’ argument on the dangers of high debt to GDP

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As President Barack Obama prepares for a second term and market talk focuses on the dangers of the U.S. fiscal cliff, economists Kenneth Rogoff and Carmen Reinhart’s debt theory is catching fire with the nation’s investment strategists.

Both MFS Investment Management Chief Investment Strategist Jim Swanson and Morgan Stanley Wealth Management Senior Fixed Income Strategist Jonathan Mackay mentioned the economic historians on Tuesday at media briefings in New York. (And so did former President Bill Clinton, who cited the moderate Republican Rogoff and Reinhart while electioneering for Obama.)

Harvard economics professors Rogoff (left) and Reinhart are well known for their epic history of finance, “This Time is Different: Eight Centuries of Financial Folly,” which uses a carefully built argument that sovereign default and high debt-to-GDP ratios–such as the one the United States is now burdened with–are disastrous for economic growth.

Clearly, the economists’ theory has become common currency as Washington’s politicians are warned about the havoc they can wreck if they fail to compromise on taxes and spending.

Mackay pointed to Rogoff’s argument that financial crises begin in a country’s banking system before spreading to the political sphere, while Swanson noted that debt-to-GDP is now higher than 80% in all G7 countries, including the United States.

“This is the mountain of debt problem that Rogoff and Reinhart have been writing about,” Swanson said. “They say you can expect to see asset collapses with 100% debt to GDP.”

In the United States, an all-out failure to reach a compromise could lead to a “Lehman-like” collapse and a 5% reduction of GDP, though what’s more likely is a “muddle through” compromise that causes a one-quarter-long recession, Swanson said.

“It’s in the interest of neither party to have an ideological win if it leads to a recession,” Swanson said. “Our view is that a deal will get done in Washington.”